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Until recently, procurement was a necessary, but seldom celebrated, component of multinational corporations. But times have changed: These days, procurement organizations within companies are playing pivotal roles in the success of global firms in ways that old-fashioned purchasing managers could never have imagined. In this special report, Wharton faculty and procurement experts at The Boston Consulting Group discuss why the procurement function has risen to such prominence in a highly competitive global environment, and how, as supplies of critical commodities tighten and prices rise, companies can strategize to mitigate these and other risks.

Part 8: Performance-based Logistics

These days, when the U.S. Department of Defense buys a fighter jet from Lockheed Martin, it doesn’t simply pay Lockheed for the physical product. Instead, the government has a “performance-based contract” with the defense supplier, according to Serguei Netessine, professor of operations and information management at Wharton. This contract says, in effect, that the government’s reimbursement to Lockheed hinges on the jets’ performance — that is, how often the planes are able to fly. In this interview, Netessine describes how performance-based contracts are becoming more common in a variety of industries.

Knowledge@Wharton: We are going to talk about something called “performance-based logistics,” and there is another interesting phrase called “power by the hour.” In some recent research that you have done, you have also talked about the aerospace industry and even Rolls-Royce, which factor into our discussion today. You worked on a research project with Morris Cohen, who is also a professor at Wharton, on this whole idea of something called performance-based logistics. Can you take a minute or two to describe what that means?

Netessine: Sure. I guess the project itself started with our joint work with Lockheed Martin. Lockheed Martin is one of the biggest suppliers to the [U.S.] Department of Defense, as they manufacture a variety of products. One of the best-known products is the Joint Strike Fighter, which is a fighter jet. … Lockheed Martin is going to be manufacturing and servicing [it] over the next 50 or 70 years and that is going to be a standard fighter jet used by all NATO nations.

So this product is extremely expensive [and] extremely costly to manufacture, but it is even costly to service because the life span of this product is very long. An airplane is going to be in service maybe 30, 40, 50 years, and over this lifetime Lockheed Martin will have to make sure the airplane is operational.

Now what the Department of Defense wants from Lockheed Martin is a performance-based contract. That is, Lockheed Martin doesn’t get paid if an airplane doesn’t fly. And this is a very radical transformation, a very radical departure from the way the Department of Defense used to operate let’s say 40, 50 and even 10 years ago. Previously, the Department of Defense would ask their suppliers to open their books and basically report to the Department of Defense how much money they spent on maintenance of military equipment. And then the Department of Defense would reimburse those suppliers and maybe give them a little something to make a small profit margin. That is how it used to work.

And for suppliers it was very easy and understandable. They didn’t really need to keep track of their costs. They could just charge whatever was necessary and then open their books and be sure that they would be reimbursed. Not anymore. Now the Department of Defense says, “I don’t care how you make this plane fly, whether you open more warehouses for spare parts or maybe you train your employees better, or maybe you design a better product. All I care about is that the plane flies.”

And now suppliers have to basically start thinking hard about how much it is going to cost them to make sure that this airplane flies most of the time. Typically the Department of Defense requires a very high availability, something like 95% of the time the plane has to fly.

So that in a nutshell is the basic idea behind performance-based logistics. You are compensated not on promise of performance and not on your cost or anything like that. You are compensated based on the actual performance of your product.

Knowledge@Wharton: When you say Lockheed Martin will be compensated for the amount of time that their planes fly, do you mean then in a sense that when the planes are mechanically fine and operational and able to fly or do you mean actually hours spent in the air doing missions?

Netessine: This is a great question and this is the kind of kink that is still being worked on. So typically what happens is the Department of Defense gives a certain forecast of how much they need to fly this plane, and there is some kind of a floor and some kind of a ceiling because everybody understands that if there is a new war, for example, then demand is going to go up and if there is a cut in the budget then demand is going to go down.

But there are certain limits within which the Department of Defense promises Lockheed Martin, for example, that the plane will be used between 1,000 and 2,000 hours in a given month. And then whenever the Department of Defense needs this plane, it has to fly 95% of the time, it has to be available 95% of the time. So it is kind of a combination. On one hand, there should be demand for flying hours from the Department of Defense. On the other hand, Lockheed Martin is protected a little bit from wild fluctuations in demand for the airplane.

Knowledge@Wharton High School

Knowledge@Wharton: The whole notion of performance-based contracting applies to other industries, not just say the Defense Department and a defense contractor. Can you discuss a couple of the other businesses, other industries that are affected by performance-based contracting or are beginning to adopt it?

Netessine: Absolutely. Actually the precursor to performance-based contracting was, I believe, an arrangement in the commercial airline industry which was called “power by the hour.” For example, if you just look at any kind of commercial airplane flown by any commercial airline, typically the engines are covered by a separate contract between the airline and engine manufacturer.

There are only a few engine manufacturers. There is General Electric, there is Pratt & Whitney, and there is Rolls-Royce, for example. And the contract even going back 10 or 20 years would basically specify that the airline pays for the flying hours of the engine. And then the engine manufacturer or any kind of a third party that is providing service for those engines has to make sure that those engines are operational whenever they are needed.

So these kinds of arrangements existed for a long time and they were basically the driving force behind this decision of the Department of Defense to switch to performance-based contracting, because over the years those relationships worked very well in commercial aerospace.

Knowledge@Wharton: And it was Rolls-Royce that coined that phrase “power by the hour?”

Netessine: I believe so. Of course, this was some years back and it is hard to trace it now, but I believe that Rolls-Royce was the first one. I also believe they probably have the best experience with those kinds of contracts. So Rolls-Royce, for example, provides engines to commercial airlines, but they also provide engines to military aircraft and military helicopters. So for them it was probably the easiest transformation to bring it from the commercial side to the military side.

Knowledge@Wharton: The industries that you’ve discussed so far are certainly key industries for the United States and really for any other industrial country. But I think that there may be some applications of this idea in the retail sector as well, and for products that may impact consumer-goods companies and average people like you and I and our listeners in terms of the products they buy. Is that true?

Netessine: Possibly. So what we have seen so far, for example, is there are a few applications of performance-based contracting. In the chemical industry, where, let’s put it simply, a chemical company needs from its supplier some kind of service, let’s say cleaning of equipment with some kind of chemicals. Previously we would see that the company would just buy those chemicals [and] pay for those chemicals to the supplier to clean the equipment. But in reality, what the company cares about is that the equipment gets cleaned. So the company doesn’t really want to buy those chemicals and care about those chemicals.

So we see a transformation toward what is called “servicization,” and servicization is kind of a bigger umbrella word for transforming the business from just buying parts, buying products, [and] procuring products to procuring services. In the chemical industry example, this would be procuring cleaning services, and you would pay for the quality of cleaning rather than for the chemicals that are used.

Another example is commercial and residential air conditioning systems. In those again, there are very large systems, and very often a building owner would buy an air conditioning system for the building and pay for the air conditioning system, and then pay for services of this air conditioning system. But really, all the owner cares about is that the system works and it delivers cold air to the building.

So a lot of companies, a lot of manufacturers of those air conditioning systems, for example, have been moving toward paying for performance. A building owner would pay the provider of an air conditioning system for the time the system is operational, paying for system uptime, for system operation 99% of the time or better.

So that’s another example of moving toward servicization and performance-based contracting, or “power by the hour.”

Knowledge@Wharton: A recent study that you and Professor Cohen worked on is titled “Performance Contracting in After-Sales Service Supply Chains,” which is a lengthy title, but it is the “after-sales service” that is interesting. That is a big component of the revenue and profitability components of companies, is it not?

Netessine: I think it is much bigger than many companies realize. There are a few studies that have been done and they demonstrated that very often when you have complex sophisticated equipment like an airplane, let’s say, companies pay much more for servicing this equipment than for buying this equipment. Moreover, this turns out to be a much more profitable line of business. On average, providing service, providing maintenance on an airplane, for example, is at least twice as profitable as selling airplanes themselves.

So I think the best class of companies has been slowly moving toward providing more and more services rather than selling equipment. A good example might be Best Buy with their Geek Squad. Geek Squad is those guys who come to your house and service your computer or TV or whatever else you might have. And this turned out to be a business that is still in high demand and a highly profitable business.

So I absolutely agree, this is becoming a huge part of our economy, and companies are realizing more and more that you can make more money by servicing rather than by selling.

Knowledge@Wharton: And is performance-based contracting or performance-based logistics a concept that executives and managers and procurement departments in companies know about now and have accepted and are thinking about and are implementing, or is it for some companies perhaps a relatively new idea that hasn’t been percolating to the executive suite yet?

Netessine: I believe it is a relatively new idea. It depends on the industry. So in commercial aerospace, for example commercial aircraft, this idea has existed for about 20 [to] 30 years now. And when you look [at] the military — how the Department of Defense did business historically — that’s a very new idea.

What executives need to understand, I believe, is that whenever you have a contract with a supplier for delivery of any kind of service, you have to think carefully about what incentives are created by such contracts. As I mentioned in the beginning, historically the Department of Defense used to, for example, reimburse all suppliers based on their costs.

Well what kind of incentives does this arrangement create? Very clearly, the supplier has absolutely no incentive to reduce costs because everything that the supplier incurs in terms of cost is going to be reimbursed. So why should I care about reducing my costs? On the contrary, I am going to inflate my costs to the extent possible. So that created very perverse incentives and great dissatisfaction with the Department of Defense with respect to efficiency of suppliers.

On the other hand, when you go to performance-based logistics and you start reimbursing suppliers just on performance of the airplane or whatever that might be — some weapons systems maybe — then both the supplier and the buyer of the service care about the same thing. The buyer wants to increase availability of the airplane and the supplier wants to increase availability of the airplane because the supplier is paid based on availability.

If you apply this kind of relatively simple thinking to any kind of relationship that the company has with suppliers, I think then we would be moving in the right direction, we would be aligning incentives of buyers and suppliers.

Knowledge@Wharton: Clearly you’ve spent a lot of time working on this issue and a lot of time thinking about it. Are there any interesting unanswered questions that you would like to address in your future research projects? What is interesting going forward for you?

Netessine: I think the biggest issue that many of those industries face right now is how exactly to measure the performance of the supplier. This gets very tricky, especially when we are talking about this kind of complicated and expensive equipment. For example, airplane engines don’t fail very often. They may fail once a year, on average. That does not give you a lot of information that allows you to assess supplier performance. So the engine failed once and the supplier, let’s say, took a week to restore this engine. And maybe a week is too long. Maybe you wanted to get it done in one day. But it is very small number.

So if your engine failed once, is that really reflective of average supplier performance or is it a random glitch that is not going to happen in the future? So this becomes very difficult. It becomes very hard to figure out whether the supplier really deployed the necessary capabilities to support this engine if the equipment fails very, very rarely. This is something that companies in aerospace and defense have been struggling with recently.

Knowledge@Wharton: One other question that you and Professor Cohen have maybe thought about. I don’t know whether you have started to formally look at this as academic researchers. Could there come a time when consumers may not want to own automobiles for instance? I mean, why pay full price for a car if it is not being used a lot or if it is not working in certain situations? Is this whole idea of performance-based contracting transferable to something like a car or a truck or another consumer product?

Netessine: Yes, more or less. With cars I think, what we see currently is if you want your car serviced at sort of no additional cost, you sign [up] for all kinds of extended warranty plans and service plans. And maybe this might be more or less an acceptable way to do it because the car is not such a complicated product.

I would maybe equate performance-based logistics in the case of cars with companies like CarShare, where you can pay for a car by the hour. If you only need a car for an hour a week or an hour a month, it doesn’t make a lot of sense for you to buy it and own it for many months or for many years. And so there are those smaller companies popping up where you can just get a car for an hour or two and pay for exactly that hour or two and forget about servicing the car and forget about paying all the other costs such as insurance.

So that might be what comes closest to performance-based logistics. But again, I think this notion of performance-based logistics applies best when products are relatively complicated and it is very hard to predict when the equipment is going to fail and how much it is going to cost to repair it. A car is still a relatively simple product. So I am not sure if it has a big future with performance-based logistics.

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